‘Disinflationary wave builds’ even as investors anticipate aggressive Fed rate hikes, says economist

Signs of disinflation have emerged even as investors fear Fed Chair Powell and his colleagues will continue to fight inflation through aggressive rate hikes that have hurt both stocks and bonds, according to a note from Capital Economics.

While it looks like the Fed may announce on Wednesday that it will raise its benchmark rate by three-quarters of a percentage point for the third time in a row, Paul Ashworth, North America chief economist at Capital Economics, expects a less aggressive monetary policy stance to follow soon.

“If we’re right that inflation will fall quickly, officials will quickly move to much smaller increases,” he said in a note Tuesday. “The continued decline in gasoline prices and easing food inflation will weigh on the overall CPI over the next month or two,” he said, referring to the consumer price index. He also pointed to signs of disinflation in the core CPI data, which excludes energy and food.

“Despite the larger-than-expected 0.6% rise in core prices in August, there are growing signs of disinflation there too,” he wrote. Supply shortages have normalized, with the company’s product shortage indicator now suggesting that “core commodity inflation could fall to 2% before the end of the year, from 7% in August,” Ashworth said.


The Federal Reserve is aiming to bring inflation back to the 2% target through monetary tightening initiated earlier this year, which wiped out stocks and bonds.

The US stock market closed lower Tuesday as investors await clues about the future path of rate hikes by the Fed after Wednesday’s two-day policy meeting.

The Dow Jones Industrial Average DJIA, -1.01%, fell 1% Tuesday, while the S&P 500 SPX, -1.13%, fell 1.1% and the Nasdaq Composite COMP, -0.95% fell nearly 1% , according to data from FactSet.

The Fed Funds rate is in a range of 2.25% to 2.5% ahead of the central bank’s projected rate hike on Wednesday. Fed futures suggest yields could peak at nearly 4.5%, according to the Capital Economics note.

“Those expectations are above our own forecasts, especially as we expect inflation to fall more sharply,” Ashworth said. Core services inflation is fueled by rapidly rising rents, “but the latest private sector measures suggest inflation for new leases is slowing significantly,” he said.

According to him, a “disinflationary wave” is building.

“There are broader signs of deflation in services, from falling airfare to hotel rates, while the decline in longer-term inflation expectations has significantly reduced the risks of a price-wage spiral,” he said. “As a result, we expect clearer and more convincing signs of a fall in inflation in the CPI data soon.”

Meanwhile, higher real returns are weighing on stock prices and pushing corporate bond spreads higher, his note shows.

For example, the ICE BofA US High Yield Index Option-Adjusted Spread index was 4.88 percentage points against comparable Treasurys on Monday, up 4.2 percentage points on Aug. 11, according to data on the Federal Reserve Bank of St. louis.

Shares of the iShares Boxx $ High Yield Corporate Bond ETF HYG, -1.02% fell about 1% Tuesday, data from FactSet shows. The fund has lost 11.6% on a total return basis through Monday this year.

See: Why rising Treasury yields are plaguing the stock market ahead of the Fed’s next rate hike

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